401(k) Guide: What It Is and How It Works

A 401(k) plan is a tax-advantaged retirement account employers offer to help their employees save for retirement.

To make the most of your 401(k) plan, we'll cover how to differentiate between different 401(k) types, choose a contribution limit and select investments to help your account grow.

What is a 401(k) plan?

A 401(k) plan is an employer-sponsored retirement account that allows employees to contribute a portion of their paycheck to save for retirement. Oftentimes, employers may match part of these contributions, but it is not required.

401(k) plans generally come in two main types: traditional and Roth. The traditional 401(k) is funded with pretax money, while the Roth 401(k) takes after-tax contributions. The type of plan you have determines what tax advantages you can receive, either now or during retirement.

How does a 401(k) work?

When you enroll in a 401(k) plan, you’re agreeing to put a percentage of your paycheck into a retirement investment account. You can select your investments — typically target-date funds and other mutual funds — based on what’s offered by your employer’s plan provider.

That money is then invested and can grow tax-deferred. When it comes time to make withdrawals in retirement, you may have to pay taxes on the money you take out, depending on the type of plan you have..

Beginning in 2025, most employers must automatically enroll eligible employees into existing 401(k) and 403(b) plans at a 3% to 10% contribution rate. The contribution rate will increase annually until it reaches a maximum of 15%. This is a change ushered in by the Secure 2.0 Act, which aims to help workers save for retirement.

What types of 401(k) plans are there?

The two main types of 401(k) plans — Roth and traditional — are differentiated by their tax advantages. Depending on the type of 401(k) plan you choose, you could get the tax benefits when you contribute the money (traditional) or when you make withdrawals in retirement (Roth). While traditional 401(k) plans are more common, many employers now offer Roth 401(k)s as well.

Traditional 401(k)

Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, and your money grows tax-free.

Once you invest in the 401(k), the money is protected from taxation. This is true for both traditional and Roth 401(k)s. As long as the funds remain in the account, you pay no taxes on any investment growth: not on interest, not on dividends and not on any investment gains.

Besides the boost to your saving power, pretax contributions to a traditional 401(k) have another benefit: They lower your total taxable income for the year.

But the tax-advantaged properties of the traditional 401(k) don’t last forever. Eventually, the IRS comes back around to take a cut. Your contributions and the investment growth are put off until you start making withdrawals from the account in retirement. At that point, you’ll owe income taxes on those distributions.

Traditional 401(k)s have one more caveat: After a certain age, account holders must take required minimum distributions, which aren’t required with a Roth 401(k).

Roth 401(k)

If your employer offers a Roth 401(k) — and not all do — you can contribute after-tax income, and your withdrawals will be tax-free in retirement.

The Roth 401(k) offers the same tax shield as a traditional 401(k) on your investments when they are in the account: You owe nothing to the IRS on the money as it grows. But, unlike with withdrawals from a regular 401(k), with a Roth, you owe the IRS nothing when you start taking qualified distributions as long as you are 59 ½ and have held the account for five years or more.

That’s because you’ve already paid your taxes since your contributions were made with post-tax dollars. And any income you get from the account — dividends, interest or capital gains — grows tax-free. When you meet the requirements for a qualified withdrawal, you and Uncle Sam are already settled up.

How much can I contribute to my 401(k)?

In 2025, the 401(k) limit is $23,500. The catch-up contribution limit for those 50 and older is $7,500, but thanks to Secure 2.0, people ages 60 to 63 can contribute up to $11,250 instead. There are no income limits restricting who can contribute to a 401(k) plan.

The last day to contribute to a 401(k) plan for 2025 is Dec. 31, 2025.

If you're wondering how much you should contribute to your 401(k), many financial professionals say you should aim to contribute 10% to 15% of your income to retirement savings. According to Fidelity Investments, the average 401(k) contribution rate was 14.1% in the last quarter of 2024, and that includes employer and employee contributions.

If 10% to 15% of your salary feels too steep, it's fine to contribute what you can and work your way up as you can afford to. You aren’t required to contribute the maximum, but it’s a good rule of thumb to consider contributing enough to get your employer match if one is offered.

What are the pros and cons of a 401(k)?

"From both a savings and investment perspective, thoughtfully designed 401(k) plans make it easy for workers to stay on track for their retirement goals," Jeff Clark, head of defined contribution research at Vanguard, said in an email interview.

Another major benefit of a 401(k) plan is that it offers higher annual contribution limits than individual retirement accounts (IRAs). In 2025, the 401(k) plan maxes out at $31,000 to $34,750 for those 50 and older. Meanwhile, an IRA tops out at $7,000, or $8,000 annually for those 50 and up.

Another pro is that many employers offer matching 401(k) contributions, which means free money going into your retirement account.

Some disadvantages of 401(k) plans are that they often offer a more limited selection of investments. That said, you can have both an IRA and a 401(k) as part of your retirement strategy if you want.

What are the 401(k) withdrawal rules?

To make a qualifying withdrawal from a traditional 401(k), you must be at least 59 ½, have a qualifying disability or qualify for a hardship withdrawal. If you don't meet these requirements, you may face a 10% early withdrawal penalty, plus you'll have to include your withdrawal as part of your income when you file taxes.

Plan participants can, however, withdraw emergency expenses of up to $1,000 per year without paying the 10% penalty. If the money isn't repaid within three years, note that no additional emergency distributions are allowed over those three years.

Still, in most cases, an early 401(k) withdrawal will trigger taxes and leave less money in the account to invest over time.

What are required minimum distributions?

Once you reach age 73, taking withdrawals from your traditional 401(k) stops being a choice. Required minimum distributions are the amounts you must take out of your 401(k) each year unless you're still working and choose to defer until retirement.

You are allowed to withdraw more than the minimum, and the distributions are included as part of your taxable income for the year. If you have a Roth 401(k), there are no required minimum distributions.

What happens to my 401(k) if I quit my job?

If you leave your job, you can take your 401(k) money with you. You can choose to roll the money into a new employer’s 401(k) plan or into an IRA. Rollovers completed within 60 days usually are not taxable. You also could choose to leave it where it is in your old employer’s plan, but you can’t keep contributing to it.

Frequently asked questions

Can I lose money in a 401(k)?

Yes, you can lose money in a 401(k) plan. Because the money is invested, there is always a risk of loss based on stock market movements.

How long does it take for my 401(k) to vest?

How long it takes for your 401(k) funds to vest, or be owned by you outright, depends on your employer and plan rules. Your contributions are always yours, but your employer's contributions might not be. In some plans, it may be vested immediately, while in others, it may be on a fixed schedule. The best way to find out is to check with your HR team or directly with your employer plan provider.

What is a solo 401(k)?

A solo 401(k) is a retirement investment account for business owners who have no employees. The plan can only cover the business owner and their spouse, if they have one. A solo 401(k), which the IRS calls a one-participant 401(k) plan, has many of the same features of a traditional 401(k) plan.